Seed Funding: Your Options and Legal Issues



Seed Funding: Your Options and Legal Issues

Dear Cathy,

I currently work in a company that manufactures detergents. It is a very profitable sector. I want to retire after three years and establish my manufacturing plant. I want to know more about my options for raising capital and the legal implications of each. –Kamau


Dear Kamau, I will answer your request through a series of articles on financing start-ups. Today I’m giving an overview and I’m going to break it down into a series of articles. Kamau, the first obvious source is personal investment or savings. Many start-ups are self-funded, which means the company founder raised capital from personal sources.

This is the simplest source of funding and, in my view, has little or no legal implications. This makes it the easiest and fastest way to raise capital.

However, the downside is that you can only raise limited amounts of money and are more exposed to risk. If your business is not making any profit, you will have lost savings.

The second source of capital is what is commonly referred to as “love or patient capital”. As its name suggests, it is capital raised from “relatives”. Borrowing from your spouse, friends and family is classified as love capital.

It is quite easy to raise compared to other formal sources of capital. Much depends on the extent of your relationship with loved ones and their willingness and ability to lend to you.

The downside is that it can strain close relationships if the terms of the loan are not met. Many friendships are broken due to unpaid concessional loans. Love capital can be conditional or unconditional. Some lenders may insist on a loan agreement which I will break down later.

The third source of capital is loan capital. This is the type of loan that is more formal and from a financial institution. Please dig deeper when borrowing from a financial institution. Get to understand the different loans available and loan terms and choose the most suitable one.

Most lenders will put you through a rigorous verification process before disbursing the funds. Some require collateral or guarantees to further secure the loan. The loan is secured by a loan agreement or, in some cases, by mortgages and other securities.

It is important to consult a lawyer to review all legal documents for you and to help you understand the loan terms.

The main covenants of a loan agreement are an agreement to repay the amount borrowed with interest on specific dates. If you default, the agreement contains what would happen in the event of default.

You may be subject to late payment interest; your security can be sold or your company liquidated! The advantage of debt is that you can raise more than the previous methods.

Fourth, equity that is raised from private investors. An investor can give you the funds you need in exchange for a percentage of ownership. When the investor acts as a co-owner of the company, various legal documents must be signed.

The shareholders’ agreement governs the relationship, decision-making, rights and income sharing between you and the investor. Some investors are for the long haul while others just want to make a profit and get out.

Your attorney will advise you on the proper documentation and structure to use under this model.

In my next columns, I will continue to demystify startup funding and the law to help you make a decision.

Ms. Mputhia is the founder of C Mputhia Advocates.


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